This is the second article in our Stochastics indicator series. If you haven’t already, we suggest that you check out the first article about the Stochastics Indicator. In the previous article, we have covered the background, the calculations involved, and how to use and read the Stochastics indicator. The Stochastics indicator is said to be “leading” since it generates signals before they appear in pricing behavior. Traders use the indicator to determine overbought and oversold conditions and the beginnings and endings of cycles in the forex market.
Forex traders focus on the Stochastics key points of reference, which are highpoints, lowpoints, divergences, and occasionally crossovers. As with any technical indicator, a Stochastics chart will never be 100% correct in the signals that it presents, but the signals are consistent enough to give a forex trader an “edge”. Skill in interpreting and understanding Stochastics indicator signals must be developed over time. In the example below, let’s develop a simple trading system based on Stochastics signals and alerts.
The following trading system is for educational purposes only. Technical analysis takes previous pricing behavior and attempts to forecast future prices, but, as we have all heard before, past results are no guarantee of future performance. With that disclaimer in mind, the “Green” circles on the above chart illustrate optimal entry and exit points for a short-selling strategy using Stochastics analysis in combination with the “divergence” noted at key decision points (Stochastics are moving counter to pricing behavior).
A simple short-selling trading system would then be:
- Determine your entry point after the “Green” Stochastics line crosses the upper extreme, diverges from pricing behavior, and the “Red” lines also crosses in an upward fashion;
- Execute a “Buy” order for no more than 2% to 3% of your account;
- Place a stop-loss order at 20 “pips” above your entry point;
- Determine your exit point after the “Green” Stochastics line dips below an extreme lower value and is crossed by the “Red” line in a downward motion (delay closing the position if divergence is noted).
Steps “2” and “3” represent prudent risk and money management principles that should be employed. This simple trading system would have yielded two profitable trades totaling 85 “pips”, but do remember that the past is no guarantee for the future. However, consistency is your objective, and hopefully, over time, Stochastics Technical Analysis will provide you with an “edge”.
That concludes our series on the Stochastics Indicator. For further reading visit our Forex indicators section.
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